Interest Rate

4 (Mishkin Ch. 4-5; Miller, Ch.7)

1. How is the market rate of interest rate

determined?
2. What is the economic function of the interest
rate?
3. What is the difference between real and nominal
interest rates?
4. What is the relationship between bond prices
and the market rate on interest?
5. How are short term and long term interest rates
related?
6. How are interest rates and risk related?
If we are under a credit less
system:

There are two options for us:

1. We can consume/exchange our
money income for goods and service
2. We can save some of our income and
hold money (store of purchasing
power)
But, if credit market emerge in an
economy:
Now, we have three options:
1. We can consume/exchange our
money income for goods and service
2. We can save some of our income and
hold money (store of purchasing
power)
3. We can lend some our saving and
earn INTEREST
Why the credit market arise:

Both lenders and borrowers can gain

from credit transaction
Different preferences for present
versus future consumption among
households
Business can make investments that
are profitable enough to pay back
interest
 Interest and The Interest Rate

If credit markets emerge in a economy,

income recipients can lend some of their
savings to others and earn interest
Interest is the amount of funds, valued
in terms of money, that lenders receive
when they extent credit.
Interest rate is the ratio of interest to the
amount lent
How interest rate change?
Interest rate are negatively related to
the price of bonds
If we can explain why bond prices
change, we can also explain why
interest rates fluctuate
We make use supply and demand
analysis for markets for bonds and
money to examine how interest rates
changes
Theory of Asset Demand:
The Determinants of Asset Demand
Approaches to the analysis of interest
rate determination

1. Loanable Funds Framework: Supply and

demand in the bond Market

2. Liquidity Preference Framework: Supply

and Demand in the Market for Money
 Supply And demand for bonds

Price Bond, Interest

P (P Rate, i (i
increase ) increase )
BS
P3 i3

P* i*

i2
P2

BD

Quantity of
Bonds, B
Market Equilibrium
Interest rate, i(%)
Demand for Bonds, Bd
(Supply of loanable funds, Ls)

Supply of Bonds, Bs
(demand for loanable funds, Ld)

Quantity of Bonds,B
(Loanable Funds, L)
Changes in equilibrium interest rates:
(1) Factors to shift the demand curve for
bonds
Change in Change in Shift in demand
Variable variable quantity curve
demanded
Income or
wealth To the right
Expected
interest rate left
Expected
inflation left

Riskiness of
bonds relative to left
other asset
Liquidity of
bonds relative to To the right
other assets
Changes in equilibrium interest rates:
(2) Factors to shift the supply curve for
bonds

Variable Change in Change in Shift in supply

variable quantity supplied curve

Profitability of
investments To the right

Expected
inflation To the right

Government
deficit To the right
Changes is expected inflation:
The Fisher Effect
Price Bond, Interest
P (P Rate, i (i
increase ) increase)
BS BS2
1
1

P1 i1

P2 i2
2

BD BD1
2
Quantity of
Bonds, B
Response to a business Cycle
expansion

Price Bond, Interest

P (P Rate, i (i
increase ) BS increase)
1
BS
2
P1 1 i1

P2 2
i2

BD2
BD
1
Quantity of
Bonds, B
2. Supply and Demand in The
Market for Money

An alternative model developed by John

Maynard Keynes
Bs + Ms = Bd + Md
Bs - Bd = Md - Ms
The equilibrium of Money Market:

Ms = Md
The equilibrium of Bond Market:

Bs = Bd
2. Supply and Demand in The
Market for Money

An alternative model developed by John

Maynard Keynes
Bs + Ms = Bd + Md
Bs - Bd = Md - Ms
The equilibrium of Money Market:

Ms = Md
The equilibrium of Bond Market:

Bs = Bd
Equilibrium in the Market for money

Interest
rate, i (%)
B Ms
i3

1
i
A
*

i2 C

Md

Quantity of
Money, M
The Allocative Role of
Interest
The rate of interest is the price of credit, it perfoms
the allocative function that all price do.
The rate of interest allocates scarce loanable funds
to the highest bidders.
By allowing credit to go to the highest bidders, it
allocates physical capital to the most profitable
businesses and durable consumer goods to those
households that are more present- oriented.
Nominal versus Real Interest
Rate

Nominal interest rate is defined as the rate of

exchange between a dollar (rupiah) today and a
dollar (rupiah) at some future time
Real interest rate is the rate of exchange between
goods and services (real things) to day and goods
and services at some future date
In a world of or inflation and deflation, nominal rate
of interest is a equal to the real rate of interest
The equation relating real
and Nominal Interest

( )
Nominal Real rate Expected Expected Real
rate of
+ + rate of x rate of
of rate of
interest interest inflation inflation interest
By assuming that interest rates and inflation rates are very small:

Nominal Real rate + Expected

rate of of rate of
interest interest inflation
Real
rate of
Nominal
rate of - Expected rate
of inflation
interest interest
Distinction Between Real
and Nominal Interest Rates
1. Real interest rate
Interest rate that is adjusted for expected
changes in the price level

ir i e

2. Real interest rate more accurately reflects

true cost of borrowing
3. When real rate is low, greater incentives to
borrow and less to lend
Distinction Between Real
and Nominal Interest Rates (cont.)
If i = 5% and e = 0% then

ir 5% 0% 5%
If i = 10% and e = 20% then

ir 10% 20% 10%

Distinction Between Interest Rates

and Returns
Rate of Return
C Pt 1 Pt
RET ic g
Pt
C
where ic current yield
Pt
pt 1 Pt
g capital gain
Pt
Key Facts about the Relationship
Between Rates and Returns

Sample of current coupon rates

and yields on government bonds
http://www.bloomberg.com/markets/iyc.html
Different Types of Nominal
Interest Rate

The Prime Rate:

The rate that bank charge on short-term loans made to large
corporation with impeccable financial credentials (most creditworthy
customer)
The corporate bond rate:
Interest rate that paid on high-grade (low risk) corporate bonds
The Federal Funds Rate:
The rate at which depository institutions borrow and lends reserves
in the federal funds market
The Calculating of
Interest Yield
1. Nominal Yield:

Rn = C/F

Where :
Rn = Nominal yield
C = Annual coupon interest payment
F = Face amount of the bond
2. Current Yield:

rc = C/P

Where:
rc= the current yield
P= price of the bond
C= annual coupon interest payment
3. Yield to Maturity on-Long Term Bonds

P = {R1/(1+r)}+{R2/(1+r)2}++{Rn/(1+r)n}

Where:
P = discounted present value
Rn= the amount of funds to be receive n-year
hence
r = the market rate of interest